Many directors of Small and Medium sized Enterprises (SMEs) which are limited companies take both a salary and dividend from the company with salaries set at a tax effective level. This is acceptable to HMRC and should not give cause for concern. The salary itself should be treated in the normal way via the payroll system and normally is.
However with dividends it’s a different story. And here problems start to arise. Not only from a compliance perspective but also because of tax issues arising.
In terms of compliance for a dividend to be valid it needs to follow certain rules. These are:
- There must be sufficient reserves in the accounts for the dividend amount to be covered.
- Where dividends are paid in the current year based on income from the current year the dividends must be after tax profits.
- The directors must have reasonable grounds that sufficient after tax profit exists. Reasonable grounds are not just an extract from Sage or other accounting software.
- The dividend must be declared in the company’s secretarial records. That is by a formal minuted resolution.
- A dividend voucher correctly drawn should be made up and submitted to the dividend recipients.
If it is found that insufficient after tax profits exist for the dividend that was drawn the dividend becomes null and void and the payment will be treated as a loan from the company and may be subject to the tax under S455.
Where the paper work does not support the dividend payments taken this exposes the payments to an attack by HMRC in that it can be argued that it is disguised remuneration.
The disguised remuneration argument will be re-enforced if, as often is the case, owners/directors do one or all of the following;
- There is an employment contract which refers to pay of salary and dividend for the work contracted
- The dividend is paid via the payroll system
- The dividend is paid regularly in the same amount at the same time (especially if done at the same time as salary payments).
- There is no paper work substantiating that a dividend was declared, or paid.
There are ways to protect oneself against an attack by HMRC. The obvious one is to remove any reference to dividend from any employment contract. Dividends can in any event never be for work performed. Dividends are a reward out of profits for the investment made.
Dividends should never be paid via the payroll system. It is not pay. Payments of dividends should be an ordinary payment out of the bank after the payment is authorised by the Board. It helps if the payment is on another day than the normal salary payment.
Regarding the paper work this is a bit more cumbersome. To cover the draws of “dividends” there should be a minute drafted by the directors stating that “draws may be made monthly in anticipation of a dividend to be declared subject to sufficient reserves being available. Where subsequently it is found that insufficient reserves exist for a dividend declaration the amounts drawn in excess must be repaid within 9 months of the financial year-end”. The directors should furthermore on a regular basis establish what the profitability of the company is. This need not be monthly and need not be a formal set of accounts but needs to be established with reasonable accuracy.
Typically that would be to take the management accounts and then to adjust these for accrued income and expenses, depreciation, estimated tax etc. A formal dividend declaration can be made after review preferably at a lower level than the adjusted after tax profits, in case of subsequent adjustments at year-end.
There is no need to pay dividends in cash and dividends can be paid by journal entries to a director’s loan account. An exception is though where there is an overdrawn director’s loan account (A debit balance) which as a result could or is subject to S455. This section says that a director’s debit loan account is subject to 25% tax if not repaid within 9 months which will be refunded by HMRC once the loan has been repaid. HMRC sees this payment to be in cash not by journal entry.
Where a debit loan amount exist but is repaid within 9 months of the year-end this is not subject to the 25% tax and it can be argued that a dividend declaration can be used through a journal entry to clear this amount. This however may be subject to a dispute with HMRC.
There are pitfalls with dividends for SME owners. But one can mitigate an attack by HMRC by doing it the right way with supporting paper work.
Richard Terhorst helps SME owners managing their financial affairs thereby improving the company’s performance. You can contact him on 0845 009 5390 or e-mail him on Richard.firstname.lastname@example.org